Four Simple Ideas to Save the Financial System

Regulators implementing the Dodd-Frank Act are writing massive, complicated rules that corporations will maneuver to exploit and federal examiners will struggle to enforce.

There has to be a better way, right? The answer is clear: we need to engage in some clean-slate thinking about fundamental issues like bank funding and capital.

Here are a few ideas.

Change the tax code. The interest that any company pays on its debt is tax-deductible. Dividends it pays on equity are not. This makes debt a much cheaper funding source than equity.

"We have a tax system that incentivizes leverage, and the regulators try to neutralize that subsidy through very complicated, increasingly complicated, means," says Bert Ely, an industry analyst with a proven knack for spotting emerging issues. "What we have is a regulatory system that is trying to compensate for the distorted incentives of the tax code."

It's not a stretch to imagine that if the tax code didn't favor debt and that led banks to hold more equity, we might not need quite so many rules or quite so many regulators.

Extend that virtuous circle further: banks holding more equity on their balance sheets would improve their credit ratings, which in turn would lower the interest rates they would have to pay on their debt.

Raise the leverage ratio and ditch Basel III. In banking, equity is not just a funding source, it's also a cushion to absorb losses.

Current regulations attempt to build this cushion in separate ways. We have "risk-based" capital rules issued by the international regulators who make up the Basel Committee on Banking Supervision and we have the "leverage" ratio issued by U.S. regulators to ensure every bank has a minimum amount of equity as a percent of its assets.

I have covered the Basel rules since their start in the late 1980s. The process has never been pretty, let alone simple. But at this point, regulators are creating rules that no one will be able to confidently comply with or competently enforce. Quite simply, Basel III is a costly, unworkable mess.

The knock against the leverage ratio is that it treats all assets the same. One type of loan or asset requires the same capital backing as any other. But honestly, doesn't that simplicity hold some appeal?

It's hard to argue that the risk-based nature of Basel works when it treats both mortgages and sovereign debt as riskless and requires no capital against either. Another problem is widespread disagreement over how to assign risk-weightings to various assets, which leads to constant cries of unfair treatment among bankers and their regulators. That will only get worse as Basel III's various extra buffers are worked out and tacked on over the coming years.

The rules to implement Basel III in the U.S. have not been written yet, so we could save everyone a lot of time, money and angst if we just went with a leverage ratio. Of course, that ratio would have to be increased and it should include off-balance-sheet assets.

But I bet a lot of bankers and even some regulators would be game to set the minimum at 8% or 10% or even 12% and call it a day. Our banks would be better capitalized, our system safer and we could forget about the ravages of regulatory arbitrage.

"The leverage ratio has the advantage of being clear and hard to fudge," says Wayne Abernathy, executive vice president for financial institutions policy at the American Bankers Association. "The problem with the fancy and complicated Basel capital rules is that they assume that a group of people can create capital models that apply across all borders and that do not need constant adjustments. They should have learned from the last recession the fallacy of that. The capital models miss a lot of risk and give a green light to what they miss."

Oppose complexity. There are plenty of other opportunities to wipe the slate clean and focus on the fundamentals. Executive compensation and consumer protection both seem like areas ripe for simple, transparent solutions.

But what we should not do is continue down this path of increasingly complex rule-writing and expect to end up with a rational, well-functioning financial system.

"No one ever stepped back and asked what kind of financial system we needed for an economy as big and diverse as the one here in the U.S.," says a federal regulator turned big-bank consultant. "We have no idea what all these changes are going to do to the business or the broader economy, since all we did was react to problems that cropped up during 2007-2009.

"Something simpler and clearer with a vision for what it will look like at the end is a better way to go, but no one will spend the time to do that type of analysis."

Perhaps no one in government, but Karen Shaw Petrou, co-founder of Federal Financial Analytics, has spent a lot of time assessing what she calls "complexity risk," or "the burden on financial institutions and regulators of complex, cross-cutting and sometimes incomprehensible rules."

Petrou calls this risk "the most significant impediment to financial-market recovery and robust economic growth." FedFin is pulling together its analysis into a white paper that will dig deep into Dodd-Frank rulemaking and propose a series of reforms to everything from corporate governance to liquidity and beyond.

Regulators must lead, not follow. What's needed is some forward thinking. It won't come from Congress or the White House. Both are too focused on next year's election.

Someone in the federal agencies needs to lead the way, but sadly, that's unlikely, too. The Federal Reserve Board is the best hope, but .

Fed Chairman Ben Bernanke is busy trying to gin up the economy. So that leaves Fed Gov. Dan Tarullo, who while certainly engaged, tends to give highbrow speeches that leave audiences scratching their heads.

And no, I haven't forgotten about the Financial Stability Oversight Council, created by Dodd-Frank, headed by the Treasury secretary and designed to spot the next problem before it blows up.

In its 15 months of operation, the council has done little to suggest it will do little more than meet periodically and issue bland reports.

U.S. regulators ought to look to the U.K. for inspiration. Adair Turner, chairman of the Financial Services Authority, and Andy Haldane, executive director of financial stability at the Bank of England, are both agitating for serious change.

Turner gave a provocative speech in February and continues to press policymakers toward more aggressive action.A speech last month by Haldane laid out four fundamental reforms, including changes to taxation that favor debt over equity.

"Postcrisis, regulatory reform has come thick and fast. These reforms are unquestionably a step in the right direction," Haldane said. But to avoid another financial crisis, he said, "deep-rooted incentive problems in banking need to be tackled at [the] source. I wish to argue there is unfinished business before these incentives are properly aligned with the public good."

Haldane backs up his points with concrete examples. In arguing that capital planning and compensation should be tied to return on assets rather than equity, he said: "Imagine if the CEOs of the seven largest U.S. banks had in 1989 agreed to index their salaries not to ROE, but to ROA. By 2007, their compensation would not have grown tenfold. Instead it would have risen from $2.8 million to $3.4 million."

It's time for our regulators to think broadly about what our financial system needs and then take a stand. Simply grinding out Dodd-Frank proposals that no one understands — like the risk-retention proposal and the Volcker Rule release — is not the answer.

Barb Rehm is American Banker's editor at large. She welcomes feedback to her column at Barbara.Rehm@SourceMedia.com. Follow her on Twitter at @barbrehm.